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If the oil market is a predictor of anything besides prices in
the future, things are about to get a lot hotter in Libya or in
Saudi Arabia, or maybe both. I see the oil market trying to
price in an escalation of further war.

Oil is priced using futures markets, where contracts are
deliverable every month. Therefore each month has a
separate contract and a uniquely traded price. When you
look at these prices placed in a time line, like a calendar, you
get a mapping of prices that can either increase or decrease the
further into the future you go. If prices generally
increase, you have a “curve” of prices called a contango, if they
tend to decrease, you have what is known as backwardation.

I’m simplifying for clarity, but a contango curve is normally
more demand sensitive, among other things – the bets in the oil
market are engaged to protect against an increasing industrial
need for oil in the future, perhaps even protecting against
future hoarding. We’ve seen a constant contango curve in
oil since 2006 and saw the most intense contango in the oil
market on a percentage basis during 2009, when oil was reaching
the nadir of its deleveraged move from the collapse of all the
markets in late 2008. What the oil market was saying during
this time was “Oil demand may be slack now, but I’m still betting
strongly on increased demand in the future”.

This is the curve we associate with emerging economy growth and
peak oil arguments as the drivers of oil price.

But in the last six weeks, we’ve had a change: A rapid move
of the curve to become much flatter and in some places to reverse
and become backwardated.

Backwardated curves tend to be more supply sensitive – the bets
in this market are more often engaged to protect against a rapid
destruction of supply choices in the near term. It will
therefore make sense to you that the most intense backwardated
oil market will emerge as the Middle East becomes disrupted and
as Western forces threaten to intervene militarily. One of the
most intense backwardation moments reached in the oil market was
in 1991, as the United States prepared to take on Saddam Hussein
in Kuwait in Gulf War I.

This backwardation has increased since NATO intervention in
Libya, implying that the military action we’ve already taken may
not be the end of it, according to the oil market.
Protecting against a “Gulf War”-like escalation seems to be what
the market is predicting today.

Two specific disruptions could fit the bill for this kind of
event: Real “boots on the ground” action in Libya by US or
NATO forces, or even a further contagion of Yemen and Bahrain
disruptions into Saudi Arabia, where the United States would be
practically forced to protect the Kingdom in a way they have not
been obligated elsewhere in the region.

The question becomes: How good is the oil market at
predicting the future? Its history has been spotty, but if
you believe in “the Wisdom of Crowds” and James Surowiecki’s
work, it’s certainly something to take seriously – the
participants engaged in trading oil are necessarily much more
attuned to the geopolitical possibilities than the rest of us.